Behind the Oil Slide (The Sky Is Not Falling)
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Behind the Oil Slide (The Sky Is Not Falling)

by | published November 1st, 2018

Despite some overall stock market recovery over the past two trading sessions plus this morning, crude oil prices are still weak.

As I write this, West Texas Intermediate (WTI), the benchmark crude rate for futures contracts in New York, is finally showing signs of stabilizing – it’s down less than a quarter of a percent.

Meanwhile, Brent, the equivalent and more widely used global benchmark set daily in London, is off 0.4%.

For the month through 11:00 a.m. this morning, WTI has shed 12.4% and Brent is off 11.7%.

Given the dynamics already well known to longtime readers of Oil & Energy Investor, the pricing should have floored and begun a rise several days ago.

In fact, as I’ll discuss in a moment, the level should never have fallen this far to begin with.

Here’s why…

The Oil Market Is a Strong One

As I’ve noted here at Oil & Energy Investor on several occasions, most recently last week (“A Saudi Ultimatum?”, October 24, 2018):

“By the time Iranian sanctions kick in (as seen in delivery schedules for the end of the year), Venezuela, Libya, Nigeria, and Iran together will contribute a decline in exports of about 3.3 million barrels a day.

There is about 2.8 million barrels a day of reliable additional exports in all of OPEC, and over 60% of that is Saudi.

Meanwhile, Russia cannot increase exports sustainably much more than present totals. And while the U.S. has plenty of excess production capacity, the ability to increase exports beyond more than 3 million barrels daily is limited by overall port and terminal capacity.”

Those underlying realities haven’t changed. And nobody I know who has any experience in this market doubts the Brent price will be touching $100 a barrel by the second quarter of 2019.

In fact, my current estimate of $90 a barrel is the most conservative read in my entire network.

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Now, we are not approaching some Armageddon moment of “Peak Oil” – the world is hardly running out of crude. Considerable excess resources exist to tap, especially in the U.S.

However, the pressures on the supply side are building, assuring that supply volatility will persist as fluctuating volume hits the market to meet continued demand. That will largely nudge prices up.

During the doldrums of 2015 and 2016, WTI was diving below $40 a barrel. At the time, those American operators who could still drill were selling whatever they could lift in a desperate “one stop ahead of the sheriff,” regardless of price or loss.

Unlike then, however, today is quite different. Even in the mid-$60 range, most American producers are working at a profit, and they can afford to leave reserves in the ground to attract a better return.

As some veteran Oil & Energy Investor readers may recall, I set up an algorithm several years back to figure out the fair value for oil when the market is roiled by turbulence. Currently, WTI is carrying a fair value of $71 a barrel; Brent $82. Those are $6 and $7 higher, respectively, than where the market puts them.

So, given all these considerations, why the slide?

Internally and Externally, Oil is Affected

This is primarily a perceptual issue. Put simply, traders are hedging bets in a very uncertain political environment.

But don’t misunderstand the cause of the oil slide. This has nothing to do with a major change in global demand (there has been none) or a sudden flood of new supply (nothing there either).

This is primarily about angst leading up to an off-year contentious election – the domestic political ingredient – and the concerns from a burgeoning American-Chinese trade war – the overriding geopolitical ingredient.

On the internal front, Trump has publicly demanded that the Saudis increase production beyond the rise Riyadh has already introduced.

Why is this a domestic U.S. issue?

Because rising oil prices mean rising prices for refined oil products. And as everybody recognizes, in a U.S. election, gasoline votes.

On the external, some pundits are pointing toward a decline on global demand. But even if there is one, it cannot be verified for about six months. Everything else (to put it kindly) is anecdotal.

But it goes even further than that…

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This Too Shall Pass

Some have been assuming that the tariff tiff will create uncertainty in Chinese economic expansion, leading to a decline in demand.

That assumption has worked its way into futures contracts, where traders need to hedge against the side on which they would lose the most. In the current climate, that is the downside – trading protection in that direction tends to overemphasize the trend.

Remember, traders are attempting to determine the expected cost of the next available barrel when setting prices on futures contracts. In times when prices are rising, that translates into a traders’ risk perception of “the most expensive next available barrel.”

In the present situation, it’s the contrary – estimating “the least expensive next available barrel.”

In either case, market fundamentals moving in a certain direction tend to have prices pushed further in that direction by trading perception.

Additionally, we have had a noticeable shift from market long positions (expecting prices to rise) to shorts (expecting prices to decline). Each short runner coming on the tube and wailing about an imminent collapse in oil prices is seeking to line his pockets via a self-justifying move in market perception.

Of course, Chicken Little here from the Sky is Falling Brokerage will quickly change his tune and move long once the perception has changed.

This oil drama recalls what the vet told me years ago when the dog ate my car keys. “Don’t worry,” she said. “This too shall pass.”

Sincerely,


Kent

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  1. Larry Horowitz
    November 1st, 2018 at 22:14 | #1

    Perhaps we may find out later that the Saudis, in order for the Trump administration to take pressure off on the Kashoggi affair, have ramped up oil production temporarily, in order to bring down gasoline prices preelection in the US. After the election, the price of oil may “miraculously” recover.

  2. Bill Prelogar
    November 2nd, 2018 at 10:57 | #2

    I am having a bit of difficulty understanding why MLPs focused on mid-stream oil and gas transportation are languishing in this period where oil and gas are being pumped and transported in record quantities. Any thoughts?

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